a. You expect an RFR of 10 percent and the market return (RM) of 14 percent. Compute the expected return for the following stocks, and plot them on an SML graph. |
Stock | Beta | E(Ri) |
U | 0.85 | |
N | 1.25 | |
D | -0.2 |
b. You ask a stockbroker what the firm's research department expects for these three stocks. The broker responds with the following information: |
Stock | Current Price | Expected Price | Expected Dividend | |
U | 22 | 24 | 0.75 | |
N | 48 | 51 | 2 | |
D | 37 | 40 | 1.25 |
Plot your estimated returns on the graph from part (a) and indicate what actions you would take with regard to these stocks. Explain your decisions. |
Part (a)
RFR = 10%
The market return, RM = 14%
The expected return for a stock using CAPM equation is: E (Ri) = RFR + Beta x (RM - RFR)
Please see the table below for E(Ri) of three stocks:
Stock | Beta | E(Ri) = RFR + Beta x (RM - RFR) |
U | 0.85 | 13.40% |
N | 1.25 | 15.00% |
D | -0.2 | 9.20% |
Plot on the SML is shown in the drawing on the white board.
Part (b)
Expected return as per research house = (Expected price + Expected dividend - Current price) / Current Price
Please see the table below:
Stock | Current Price | Expected Price | Expected Dividend | Expected return as per research house | E (Ri) as calculated in part (a) | Decision | Action |
CP | EP | ED | ER = (EP + ED - CP) / CP | ||||
U | 22 | 24 | 0.75 | 12.5% | 13.4% | Overvalued | Sell |
N | 48 | 51 | 2 | 10.4% | 15.0% | Overvalued | Sell |
D | 37 | 40 | 1.25 | 11.5% | 9.2% | Undervalued | Buy |
The plot is shown on the white board. U* represents the expected return as per the research house for stock U and so on....
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